Knowledge that Transforms

[Hellwig's (1980) model is used to analyze the value of improving trading opportunities by more frequent trading in the underlying asset, or by trading in a derivative asset. With multiple trading sessions, uninformed investors behave as rational trend followers, while more informed investors follow a contrarian strategy. As trading becomes continuous, Pareto efficiency is achieved. With trading in an appropriate derivative security, Pareto efficiency may be achieved in only a single round of trading. All derivative claims are then priced on Black and Scholes (1973) principles and, in the absence of further supply shocks, no trading will take place in subsequent trading rounds.]

[We use futures transaction data to investigate cross-sectional relationships between market-maker inventory positions and trade activity. The investigation documents strongly that traders control inventory throughout the trading day. Despite this evidence of inventory management, typical inventory control models are contradicted by our data. These inventory models predict that market-maker reservation prices are negatively influenced by inventory. Surprisingly, our evidence shows, as a strong and consistent empirical regularity, that correlations between inventory and reservation prices are positive. We interpret the evidence as consistent with active position taking by futures market floor traders.]

[We use a cost of carry model with nonzero transaction costs to motivate estimation of a nonlinear dynamic relationship between the S&P 500 futures and cash indexes. Discontinuous arbitrage suggests that a threshold error correction mechanism may characterize many aspects of the relationship between the futures and cash indexes. We use minute-by-minute data on the S&P 500 futures and cash indexes. The results indicate that nonlinear dynamics are important and related to arbitrage, and suggest that arbitrage is associated with more rapid convergence of the basis to the cost of carry than would be indicated by a linear model.]

[We develop lower and upper bounds on the prices of American call and put options written on a dividend-paying asset. We provide two option price approximations, one based on the lower bound (termed LBA) and one based on both bounds (termed LUBA). The LUBA approximation has an average accuracy comparable to a 1,000-step binomial tree with a computation speed comparable to a 50-step binomial tree. We introduce a modification of the binomial method (termed BBSR) that is very simple to implement and performs remarkably well. We also conduct a careful large-scale evaluation of many recent methods for computing American option prices.]

[We compare acquisitions completed with and without investment bank advice over the 1981 to 1992 period. We find that the choice to use an investment bank depends on the complexity of the transaction, the type of transaction (takeovers versus acquisitions of assets), the acquiror's prior acquisition experience, and the degree of diversification of the target firm. Although acquisition announcement returns are lower for firms using investment banks, this difference can be explained by differences in transaction characteristics. These results suggest that transaction costs are the main determinant of investment banking choice, followed by contracting costs and asymmetric information costs.]

[This article examines the stock-price effects of top management turnover announcements for 432 Japanese corporations from 1985 to 1990. We find that these announcements are associated with significantly positive abnormal returns. The returns are greater when turnover is forced than when turnover represents normal succession. The stock-price effects are also significantly positive when turnover is forced and the successor is appointed from outside the firm. We find that large shareholders play an important role during outside succession. This evidence suggests that the disciplinary decisions of Japanese governance mechanisms are consistent with shareholder wealth maximization.]

[We present two ways in which trading in a replicatable option can affect the price process of the underlying asset. In the first situation, trading an option that each investor views as payoff redundant breaks a non-fully revealing equilibrium that exists when the option market is absent. The second situation involves a market that is dynamically complete without options, but in which introducing an option market allows self-confirming conjectures of additional uncertainty about the future price of the underlying asset. Heterogeneous beliefs play important though different roles in both situations.]

[This article develops a model of the upstairs market where order size, beliefs, and prices are determined endogenously. We test the model's predictions using unique data for 5,625 equity trades during the period 1985 to 1992 that are known to be upstairs transactions and are identified as either buyer or seller initiated. We find that price movements prior to the trade date are significantly positively related to trade size, consistent with information leakage as the block is "shopped" upstairs. Further, the temporary price impact or liquidity effect is a concave function of order size, which may result from upstairs intermediation.]

[We provide experimental evidence that nonbinding preplay communication between bidders in auctions of shares facilitates the adoption of equilibrium strategies: collusive strategies in uniform-price auctions, and the unique equilibrium in undominated strategies in discriminatory auctions. When communication between bidders is introduced, clearing prices and auctioneer profits in uniform-price auctions fall below those observed in discriminatory auctions. This evidence suggests that uniform-price auctions of Treasury securities may result in lower revenues than the currently employed discriminatory procedure.]

[This article describes the relation between closed-end fund discounts and time-varying expected excess returns on small firms. The results indicate that closed-end fund discounts forecast future excess returns on small firms. The information in discounts is independent of that in other commonly used forecasting variables such as the dividend yield on the market, the default spread, and the term spread. Furthermore, the closed-end fund discount forecasts only the small firm factor return and is the only variable that forecasts the small firm factor return. Additional tests indicate that the information in discounts is related to expectations of future earnings growth and expectations of future inflation. These results provide significant support for a rational explanation of the time-series relationship between discounts and expected returns on small firms.]